Wednesday, July 20, 2016

Young means Equity &The Fallacy of time diversification


From my earlier post against diversification, let me take time to address the flawed logic people have about diversification which is captured well in Jordan, Miller and Dolvin book on Valuation and Management.
Has anyone ever told you “ You’re young, so you should have a large amount of equity in your portfolio?  I know some of the people I coached during my early days of the Investment Coaching would say, Yes Patrick, you told me that. Well, while this advice could be true, the argument frequently used to support the strategy is generally incorrect. People say, although stocks are more volatile in any given year, over time this volatility cancels itself out. Investment professionals say this is a flawed argument. And they refer to the phenomenon as time diversification fallacy.
Jordan, Miller and Dolvin helped with this line of reasoning. You might remember from your statistics class that we can add  variances together. The fact means that annual variance grows each year by multiplying annual variance by the number of years. Standard deviations (SD) cannot be added together because the SD is the square root of the variance, however, an annual SD grows each year by the square roots of the number of years.  This feature is very handy when we are describing the returns and risk of an investment.  For example, If  we take a randomly selected portfolio of large –cap stocks of standard deviation of about 20%, and hold this portfolio for 16 years, the SD would be about 80%, which is 20% multiplied by the square root of 16.

Bottom line: Volatility increases over time – Volatility does not “cancel out” over time.  Whiles investing in equity gives you a large chance of having a portfolio with extremely large value, it also increases the probability of ending with a really low value.
So, should younger investors put more money into equity?  Probably YES, but for a more logical reason other than the reasoning underlying the fallacy of time diversification.

It is advised by professionals that, if you are young and your portfolio suffers a steep decline in a particular year, you should make up for this loss by changing your work habits / job / source of income or getting a second source of income.  People approaching retirement have little future earning power hence a major loss will have larger impact on their wealth no wonder the young should rather consider more equity.

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